~ A blog about financial markets, the economy and other topical issues of the day

Dividend stocks: there’s perception and there’s reality

I know a few things about higher dividend paying stocks relative to lower dividend paying stocks. For one, there’s credible evidence that higher yielders will outperform lower yielders over the long-term (most of this evidence relies on time series data involving decade’s worth of performance). Likewise, there is credible evidence that higher dividend paying stocks will outperform lower dividend paying stocks in bear markets. We pointed this out in a blog post earlier in the week. Part of the reason for this outperformance in declining markets has to do with investor’s desire for a “dividend cushion”. Another part relates to the signaling nature of the dividend. The dividend alone reveals that a company has enough balance sheet strength and capacity to return cash payments to shareholders.

I also know that during the full calendar year 2011 that dividend paying stocks outperformed their non-dividend paying brethren. In the S&P 500, for example, dividend paying stocks were positive during the year while non-dividend paying stocks were negative. I get all of this because it is based on substantiated and data-driven fact.

Then there’s this: “Dividend paying stocks are on a roll”, according to a recent headline in USA Today. Or a recent Financial Times article stating, “One reason to adopt this strategy [investing in high dividend paying stocks] is clear. The herd is galloping towards stocks that pay a decent and well-supported dividend. It would be unwise to get in their way. But how long will the herd keep galloping this way? I suspect it could be a while.” Or the countless number of guests on the financial cable shows who have pounded the table over the past six months in support of dividend paying stocks due to their relative safety (which is legitimate) and supposed recent outperformance (which is not). One ‘5-Star mutual fund manager’ on CNBC yesterday afternoon said that “dividend paying stocks have been outperforming for most of the year.” I hear and read this type of stuff all the time.

The problem is that these pronouncements are not completely accurate. Yes, there is evidence that investors are running for dividend related investments, but based on the performance figures over the past year, you’d have been better off running the other way. The graph below shows the average total return of stocks with the highest 1/3rd in dividend yield in the S&P 500 (excluding the few stocks with exceptionally high yields which undoubtedly resulted from a precipitous drop in stock price) and those with the lowest 1/3rd in dividend yield within the S&P. The graph clearly shows that within the past year, low dividend paying stocks are, on average, trouncing ones with higher dividends. I intentionally show multiple periods (e.g. ‘YTD 5/23′ means year-to-date thru 5/23/12) due to the recent equity market rally where there has been a sector rotation out of classical higher yielding defensive sectors into the lower dividend-paying cyclicals. Over any time frame in the past year, however, lower dividends have outperformed.

Why should any of this matter? For two primary reasons: first, for the retail investor, this is a classic example of performance chasing. Mean reversion makes it more difficult for the leaders of yesterday to be the leaders of tomorrow. Should a retail investor heavy-up on dividend payers at the expense of lighter exposure to lower yielders at this point? It could definitely make sense for a long-term buy and hold strategy based on the fact that dividend payers outperform over the long-term. It could also make sense given a forecast of a market correction. But, if you’ve been following the advice of some of these pundits, there’s no question that you’ve sacrificed profits over the recent past by foregoing investment in the low yielders.

This leads to the second reason on why this matters. In my past life, I worked at a fund of funds shop, allocating huge chunks of money to hedge fund managers. As you might expect, past manager performance differentiated one manager from another. But, it was also my experience that an even more important variable determining future performance depended on the manager’s understanding of return attribution–what worked and what didn’t over the past. Money management is based on using past knowledge to help predict future events that are uncertain. For this reason, one should be careful about using the assistance of others to guide them through an uncertain financial future if they haven’t proven an understanding of a knowable past.